In spite of persistent unemployment and widespread negative sentiment, the stock market has roared back to life in the past 14 months. And while the broader market, as measured by the S&P 500, has done extremely well, some sectors of the market have done even better. Small-cap stocks have been one of the big winners, even over the past decade. But don't go betting the farm on these pint-size companies just yet. Their days in the sun may be drawing to a close.
Changes ahead
Of course, it's difficult to present the case that small caps may be due for a breather without people reminding you that historically, small-cap stocks have outperformed their larger brethren over the past several decades. That much is true. And I'm not postulating that that long-term trend will reverse. However, within that longer time frame, market leadership can run in smaller cycles, and investors need to realize that odds are good that small caps won't continue to lead the market in the coming quarters.
First of all, consider how much ground small-cap names have covered in the past year. While the S&P 500 is up nearly 80% from its March 2009 lows, the Russell 2000 index has more than doubled over the same time. Most investors are aware that lower-quality names have dominated in this rally, and those lower-quality names tend to include smaller companies.
That disparity in returns is even more marked when you look out over the past decade. Since June 2000, large-cap stocks have actually lost 0.3% a year, while small-cap names have posted a 4.9% annualized gain. That's a pretty meaningful difference. While small-caps have more room to grow given their smaller stature, they have definitely made a lot more money in the past 10 years than larger names. And given their recent run-up, it's hard to argue that smaller names are as reasonably priced as they were a year ago.
Furthermore, while investors have been wary about investing in domestic stocks in general, when they have ventured into U.S. stock funds, they've typically done so to buy smaller names. In the past year, small-cap funds have taken in several billion dollars worth of inflows, while large-cap funds have lost billions of dollars. When investors end up piling into one asset class, that's a sure sign that its heyday is close to being over.
The next big thing
Of course, there are some smaller stocks that still represent good bargains even now. Niche consumer companies American Eagle Outfitters (NYSE: AEO) and PetSmart (Nasdaq: PETM) are two stocks that I believe have a lot of upside potential. American Eagle is pushing its aerie brand, which appears to be extremely promising, while continuing to enjoy its strong brand acceptance among teenagers and young adults. Likewise, PetSmart is well-positioned within its industry and has nearly twice the sales of its nearest competitor.
But if you're looking to corner the market on the next stage of this bull run, bigger is better. Given that the stock market is probably pretty fully valued right now, investors should pay careful attention to valuations when buying large-cap stocks. Along this vein, I like Best Buy (NYSE: BBY) and Coca-Cola (NYSE: KO), which are trading at below-average valuations compared to the rest of their peers while sporting much higher sales growth rates. And while home improvement retailer Lowe's (NYSE: LOW) is trading close to the P/E average for its industry, it boasts higher gross margins than its peers, has a strong balance sheet, and should benefit as the housing market continues to stabilize.
Keeping balance
To be clear, I'm not saying that investors should ditch their small-cap funds and holdings and shift that money into larger stocks. I'd recommend maintaining your long-term allocation to small-cap stocks. Small caps should continue to post fairly decent returns in the coming years, so this is one segment of the market you don't want to miss out on. However, if your portfolio is overweighted to small caps as a result of their recent rally, make sure you rebalance back to your target weights.
Even though small caps should do well, investors should be prepared for market leadership to begin to shift in the near future. As the bull market matures, higher-quality, stable large-cap names are likely to be the next winners. If you have new money to put to work, try to beef up your large-cap allocation as a first priority, either by adding to your existing large-cap funds or by snapping up a few high-quality stocks. Small caps may be sexy, but sometimes you need the stability of larger names to ground your portfolio. The next few years are likely to be one of those times.
